Is It Cancellation of Debt Income?

By Larry Jones
© 2011 CCH. All Rights Reserved.

Introduction
Cancellation of debt income is something that can sneak up on an unsuspecting taxpayer. The definition of cancellation of debt income is simple: A taxpayer owes a debt and the lender forgives all or part of the debt. The amount forgiven is ordinary income. While the definition may be simple, the rules may not be so simple.1 There are some exceptions. In the following situations, cancellation of debt income is not taxable: bankruptcy, insolvency, certain farm debts and in some cases where a nonrecourse debt is involved. A common situation is where a taxpayer loses his or her home through foreclosure or does not pay a credit card debt, and the lender in either case cancels the debt.

A lender who acquires a taxpayer’s property through foreclosure, repossession or abandonment should send the taxpayer Form 1099-A, Acquisition or Abandonment of Secured Property. Form 1099-A gives the debtor and the IRS the following information:

1. Date of the lender’s acquisition or knowledge of abandonment
2. Balance of the principal outstanding
3. Fair market value of the property
4. Whether the borrower was personally liable for repayment of the debt
5. Description of the property

Form 1099-A should only be issued if there is no cancellation of debt in excess of the value of the property. This form is used by the taxpayer to calculate gain or loss and any ordinary income from cancellation of debt.

If a lender cancels all or part of the debt of a taxpayer, the lender is required to send the taxpayer Form 1099-C, Cancellation of Debt. Form 1099-C gives the taxpayer the following information to be used in determining the tax consequences of the transaction:

1. Date the debt was canceled
2. Amount of debt that was canceled
3. Debt description
4. Whether the borrower was personally liable for repayment of the debt
5. Fair market value of the property

Form 1099-C is required to be filed with the IRS. In many cases the taxpayer does not receive Form 1099-C or fails to report the cancellation of debt income. Through the IRS matching process, the IRS computer determines that the income has not been reported on the taxpayer’s return for the year in question, and the taxpayer is sent a letter, CP-2000, advising the taxpayer that the income has not been reported on the taxpayer’s tax return. If the taxpayer agrees, the taxpayer can sign a form included in the letter, and the IRS will make an additional assessment against the taxpayer. In many cases the taxpayer disregards the CP-2000 letter, and the IRS will issue a notice of deficiency.

Often the receipt of a Form 1099-C comes as a surprise to the taxpayer. A taxpayer may have negotiated a reduction in the debt without any knowledge that there is a tax issue looming in the wings. A number of factual situations can result in the lender canceling the balance of the debt and sending Form 1099-C to the taxpayer. One situation is in the case of a short sale. The Tax Court has defined a short sale as follows:2
A “short sale” in real estate occurs when the outstanding loans against a property are greater than what the property is worth and the lender agrees to accept less than it is owed to permit a sale of the property that secures its note.

In order to avoid a foreclosure that would affect their credit, some taxpayers agree to the short sale without realizing the tax consequences of the short sale.3

Another example where a taxpayer is deemed to have cancellation of debt income is where the taxpayer negotiates with a credit card company to reduce the taxpayer’s credit card debt. Only in rare cases will forgiveness not be considered cancellation of debt income.

The Law
Gross income under Code Sec. 61 includes income from whatever source derived. Code Sec. 61(a)(12) specifically provides that discharge of indebtedness is income.4 The general rule, subject to exception set forth above, is that a taxpayer must include cancellation of debt income in the taxpayer’s income in the year the debt becomes worthless. The difference between the face amount of the debt and what is paid in satisfaction of the debt is included in income. If the debt is non non-recourse, the amount to be included in income is the full amount remaining on the debt. When a taxpayer fails to include discharge of debt in income, the IRS uses the amount shown on Form 1099-C as the basis of the proposed assessment.

The IRS must issue a statutory notice of deficiency before an assessment can be made. This gives the taxpayer the right to file suit in the U.S. Tax Court to contest the amount of income alleged to result from a discharge of indebtedness. Items set forth in a notice of deficiency are deemed to be correct, and the taxpayer has the burden of proof in establishing the IRS’s determination is incorrect.5 Code Sec. 6201(d) states as follows:

Required reasonable verification of information returns

In any court proceeding, if a taxpayer asserts a reasonable dispute with respect to any item of income reported on an information return filed with the Secretary under subpart B or C of part III of subchapter A of chapter 61 by a third party and the taxpayer has fully cooperated with the Secretary (including providing, within a reasonable period of time, access to and inspection of all witnesses, information, and documents within the control of the taxpayer as reasonably requested by the Secretary), the Secretary shall have the burden of producing reasonable and probative information concerning such deficiency in addition to such information return.

In most cases this statute should apply. While it refers to cooperation, there is really no chance for the taxpayer to cooperate, since the IRS considers the Form 1099-C to be true and correct.

The debt is viewed to be discharged at the time it is determined that it will never be repaid.6 The
Regulations give a list of “identifiable events” under which a debt is discharged for information reporting.7 Whether there has been a cancellation of the debt generally turns on the facts of each case. While the issuance of Form 1099-C may be considered an identifiable event, it is not necessarily determinative of whether there was an intent to cancel the debt.8

Representing the Taxpayer with Cancellation of Debt Income

1. The first thing to determine when the cancellation of debt income issue is raised is: Is it really cancellation of debt or should it be treated as something else? This requires a full development of the facts. Form 1099-C is not always prepared correctly. Further, it is difficult for the taxpayer in most cases to get the lender to correct Form 1099-C.
2. Was the debt actually canceled and was it canceled in the year shown on Form 1099-C?
3. Is the liability disputed? In many cases where there is a dispute with a creditor and the debt is resolved for less than is owed, the creditor will consider the unpaid amount as cancellation of the debt. In these cases the creditor will issue Form 1099-C. There must be a genuine dispute as to the amount of the debt.9
4. Is the debt recourse or nonrecourse? The rules here are somewhat complicated and depend on a number of factors.10
5. Does the insolvency exception under Code Sec.108 apply?

Conclusion
In situations where there has been a cancellation of debt by a creditor, if the taxpayer disputes the cancellation, prompt action should be taken in an attempt to have the lender correct Form 1099-C. In most cases it is difficult, if not impossible, to convince the lender to make the correction. The best alternative is to file a Tax Court petition and deal with the IRS Appeals Officer or IRS attorneys.

Endnotes
1 This article addresses only the basics of cancellation of debt income. It does not cover in detail when a recourse or nonrecourse debt is involved; when there is a foreclosure; or whether the debt might be joint or separate, calculation of insolvency, community property, tax attribute reductions and reduction of basis.
2 G.E. Stevens, T.C. Summary Opinion 2008-61, 2008 Tax Ct. Summary LEXIS 62 (June 3, 2008). Although Summary Opinions are not to be cited as precedent, this case sets forth a good example.
3 H.R. 3648, the Mortgage Forgiveness Debt Relief Act of 2007. Under this Act, if a home was foreclosed on there could be cancellation of debt income. With certain exceptions discharge of debt involving a personal residence is excluded from the taxpayer’s income.

4 Reg. §1.61-12(a).
5 Tax Court Rule 142(a)(1); T.H. Welch, SCt, 3 USTC ¶1164, 290 US 111 (1933).
6 J.R. Cozzi, 88 TC 435, Dec. 43,718 (1987).
7 Reg. §1.6050P-1(b)(2)(i).
8 C.B. Owens, 84 TCM 419, Dec. 54,898(M), TC Memo. 2002-253, aff’d, rev’d and rem’d TC in an unreported per curiam opinion, CA-5, 2003-1 USTC ¶50,518.
9 D. Zarin, CA-3, 90-2 USTC ¶50,530, 916 F2d 110.
10 J.F. Tufts, SCt, 83-1 USTC ¶9328, 461 US 300 (1983).

About the Author
Larry Jones is a Partner in the Dallas offi ce of Townsend & Jones, L.L.P., and focuses his practice on tax controversy matters. He is also Director of the SMU Dedman School of Law Tax Clinic and teaches Federal Tax Procedure at the law school. Larry can be reached at larry@tjtaxlaw.com.